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Prior to the market open on Wednesday, ConocoPhillips (COP) reported earnings that generally beat significantly reduced estimates. This earnings report was more interesting than normal since it was the first independent report since the company split from Phillips 66 (PSX).

Following completion of the split, ConocoPhillips claims to now be the world's largest independent exploration and production company, based on proved reserves and production of liquids and natural gas.

Q2 2012 Earnings Highlights

The headline earnings numbers of $2.3B in net income and $1.80 per share are misleading as those numbers include one month of the divested business and a large gain from asset sales.

The adjusted earnings excluding those one time numbers show that the company earned $1.22 compared to analyst estimates at $1.17.

See below highlights from the earnings report:

  • Adjusted earnings were $1.5 billion, or $1.22 per share, compared with second-quarter 2011 adjusted earnings of $2.3 billion, or $1.64 per share.
  • Completed spinoff of downstream businesses into Phillips 66.
  • Achieved production of 1.54 million BOE per day.
  • Continued progress on North American unconventional programs.
  • Progressed Australia Pacific LNG's project with sanction of second train in early July.
  • Initiated drilling and acquired additional leases in deepwater Gulf of Mexico.
  • Completed disposition of Alba and Statfjord fields.
  • Repurchased 52 million ConocoPhillips shares, representing 4 percent of outstanding shares.
  • Paid quarterly dividend of 66 cents per share, consistent with pre-spinoff levels.

Production Review

Now that ConocoPhillips is an independent exploration and production company the top focus for investors will move towards whether it can actually grow production. Per the CEO, the company plans for 3 to 5% production growth on an annual basis.

The initial results are underwhelming with production of 1.54 million BOE per day, compared to 1.64 million BOE per day for the Q2 2011 period. The company blamed the reduced amounts on impacts of the disposition and maintenance downtime.

At least the Eagle Ford, Bakken, and Permian shales contributed 54,000 BOE per day of production more than last year. At a total of 137,000 BOE per day, the three areas grew by more than 60% from last year. The Canadian oil sands also contributed 20,000 BOE per day more production as well though the company wasn't clear on the base amount. These amounts weren't nearly enough to make up for lost production elsewhere.

The realized price of crude oil decreased to $105.56 per barrel from an extraordinarily high $112.95 per barrel in Q2 2011. Most investors would be happy to see the Q2 2012 prices sustained.

The realized price for natural gas decreased 20% to $4.41 per thousand cubic feet (MCF).

Net Payouts

ConocoPhillips remains one of the largest net payout yield (NPY) companies around. During the second quarter of 2012, the company repurchased 52M shares, or roughly 4% of the outstanding shares, for $3.1B.

The dividend remains at $0.66 per quarter providing for a 4.7% yield. Combined with the buyback yield, the stock has yielded over 5% in 3 of the last 4 quarters alone.

Cash provided by continuing operating activities was $2.2 billion, reflecting a $0.8 billion increase in working capital. The company also received $0.5 billion in proceeds from asset dispositions and increased debt by $0.8 billion.

The cash flow suggests the buyback level might need to decline in the near future unless the company plans to use some of the proceeds from the $8-10B in assets it expects from the disposition program.

The below chart highlights the NPY over the last 5 quarters.

(click to enlarge)

Valuation

The stock remains cheap especially considering the cash flow and the ability to fund such an aggressive shareholder payout plan. Investors are getting paid nearly 5% to wait while the company reduces shares outstanding by over 10% a year. If the production targets can be achieved, earnings growth could easily exceed the 15% level.

The stock trades at roughly 9x the analyst estimates of $5.77 for 2013. Based on the slight earnings beat, these estimates are likely to increase making the forward PE even lower.

As an example, much larger Exxon Mobil (XOM) trades at a higher 11x forward estimates. This disparity in valuations could provide the stock some room for gains.

Conclusion

This stock remains cheap especially considering the very high NPY. Investors are likely to remain skeptical on whether the company can in fact turn around production declines. Until then, investors should just sit back and collect the large dividends while the company repurchases its own stock on the cheap. Down the road, the stock should gain from all the repurchased shares providing for a nice gain.

Source: ConocoPhillips Reports Solid Yields, Concerning Production Declines

Additional disclosure: Please consult your financial advisor before making any investment decisions.